Improving Nondiscrimination Test Results

March 25, 2013 (PLANSPONSOR.com) - Many plan sponsors would like to avoid returning excess contributions to their highly compensated employees, so how can they improve their nondiscrimination test results?

Generally, nondiscrimination testing is comparing the contributions of non-highly compensated employees (NHCEs) to the contributions of highly compensated employees (HCEs). If the HCEs exceed prescribed Internal Revenue Service (IRS) limits, then corrective action will be needed in the form of returning HCE contributions or making additional employer contributions on behalf of NHCEs.

The nondiscrimination test most plan sponsors are familiar with is the ADP test, or actual deferral percentage test, because it is the test that fails most often. The ADP test compares the deferrals made by NHCEs to those made by HCEs. Of the plans for which Fidelity performs the ADP test, approximately 35% fail the test and need to take some type of corrective action. Most often this corrective action is refunding to HCEs their deferrals that exceeded the IRS limits. This is often a big source of dissatisfaction with plan administrators, as well as the HCEs. The actual contribution percentage (ACP) test compares employer matching and after-tax contributions made on behalf of NHCEs to those made on behalf of HCEs.

There are several options for improving test results, some of which may be easy to implement.

QNECs

The first thing a plan sponsor should consider is making a targeted qualified non-elective contribution (QNEC) on behalf of NHCEs so they pass the test. A QNEC is an employer contribution that can be used by 401(k) plans to ensure the ADP and/or ACP tests are satisfied without having to refund contributions to highly compensated employees (HCEs). The plan sponsor’s service provider can likely provide the amount of the QNEC required to pass the test.

Depending on the plan demographics, targeted QNECs may be a very cost effective way to pass the test and eliminate returning contributions to HCEs. They are essentially limited to 5% of compensation so, while they may not be practical for every plan, they can be very beneficial for some. When they do work, it’s a win-win. HCEs keep their deferrals in the plan and NHCEs receive additional contributions. If the plan does not currently allow for the targeted QNEC, then it may be a good time to consider amending the plan to allow for it in the future. Also, if your plan uses prior year testing, your correction period is limited. Nonetheless, it’s an option worth exploring.

Other Options

Specifically for nondiscrimination testing, the regulations offer multiple standard and alternative definitions of compensation. Using a different form of compensation for nondiscrimination testing may provide better results. For example, ADP/ACP test results could be improved by excluding compensation for the period prior to the date that employees become eligible.

The plan could “shift” deferrals to the ACP test or shift qualified matching contributions to the ADP test. A plan sponsor may be able to improve or optimize the position of the plan by moving "excess percentages" from the ADP test to the ACP test. Qualified matching contributions may be shifted in a similar way from the ACP test to the ADP test.

The plan could use permissive disaggregation. Permissive disaggregation can be used when the plan's eligibility requirements are more lenient than the statutory eligibility requirements (one year of service, attainment of age 21, and semi-annual entry date). It involves separating the eligible employee group into two sub-groups: those eligible employees who meet the statutory eligibility requirements, and those employees who do not meet the statutory eligibility requirements. The ADP, ACP and 410(b) minimum coverage tests are then performed on each sub-group independently and most often produce an improved test result.

Finally, the plan sponsor could consider amending to a safe harbor plan which would eliminate the need for testing. For a 401(k) plan to be considered a safe harbor plan, employers must satisfy certain contribution, vesting and notice requirements listed in IRC Section 401(k)(12). By satisfying these conditions, a safe harbor plan is generally deemed to pass ADP/ACP nondiscrimination tests and may be deemed to satisfy the top heavy requirements as well.

Prior Year vs. Current Year

If a plan uses prior year testing, the HCE contributions are compared to the NHCE contributions for the prior year. Current year testing compares the HCE contributions to the NHCE contributions for the current year. The primary advantage of using prior year testing is the IRS limit for the HCEs will be known early in the plan year so a plan sponsor can predict the results and, if they choose, limit HCE contributions for the year.

Current year testing loses the predictability of the results but has other advantages. QNECs, as described earlier, relatively speaking, have a longer correction window with current year testing.Also, current year testing would be preferred if a plan sponsor is not certain matching contributions are going to be made from year to year. Current year testing sets limits on contributions made in the actual year (whereas prior year testing would set a limit of $0 if no matching contributions were made in the prior year).

As one plan sponsor said, “there are enough of these rules to fill a battleship.”With all the responsibilities a plan sponsor has, it is difficult to learn all the complexities of plan administration, let alone nondiscrimination testing. To get the best nondiscrimination test results and the optimal design for your plan, ask your provider what your options are.